Our previous posts on salt water disposal covered provided an overview of the sector and detailed the economics of the industry. In this post, we’ll be taking a deeper dive into specific considerations that are critical to understanding the value of salt water disposal companies.
What Does the Valuation Process Entail?
There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.
The Asset-Based Approach
The asset-based approach can be applied in different ways, but the general idea is that the equity value of a business is given by subtracting the market value of liabilities from the market value of assets. However, the value of these assets is not always readily available and must be established through other methods, such as the market approach and the income approach. These values can also sometimes be proxied by replacement costs or build multiples, though location and intangible items (like permits and contracts) can make the asset-based approach challenging.
The Income Approach
The income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.
As discussed in our previous post, cash flows are generally a function of disposal fees and the volume of water processed (with some incremental potential revenue coming from selling oil “skimmed” from the water), less cash operating costs.
While some cash flow growth may be driven by operational efficiencies and increasing utilization rates, there is less potential for organic growth relative to other industries given capacity limitations and permitting requirements. Most growth will come in the form of increasing capacity, which requires capital expenditures. And as the sector continues to be the recipient of significant public and private capital, the economics of new projects may deteriorate.
The riskiness of the cash flows is determined in part by the contract mix and location. Longer contracts with minimum volume commitments or take-or-pay requirements serve to reduce the risk of the cash flow stream. Uncontracted volumes or shorter contracts based on acreage dedications serve to increase the risk of the cash flow stream. Additionally, salt water disposal operators are subject to a host of regulatory and environmental risks, including concerns regarding potential links between SWD wells and seismic activity.
The Market Approach
The market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.
In many industries, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. While there are numerous publicly traded companies with salt water disposal operations, none are “pure play.”
In fact, the salt water disposal sector sits at an interesting nexus between three oil & gas verticals: exploration & production, midstream, and oilfield services. Rattler Midstream went public in 2019 as a carve-out of E&P company Diamondback Energy. Most of Rattler’s revenues are attributable to salt water disposal operations. NGL Energy Partners was a traditional midstream company providing pipeline transportation for crude oil, NGLs, and refined products. However, over the past several years, it has transitioned its focus to water, with water solutions expected to generate over half of the company’s EBITDA going forward. Select Energy Services is an oilfield services company that provides water-focused services including flowback and well testing, water storage, and fluids handling, but is increasingly investing in pipeline infrastructure and SWD wells.
As such, there must be careful consideration of the appropriateness of using public company multiples given operational, size, and geographic differences, among other factors.
Fortunately, there have been numerous acquisitions of smaller, private companies in the sector, and valuation multiples can be derived from these transactions. However, this data is often self-reported, and there can be inconsistencies across transactions for both the implied transaction values (e.g., treatment of earnouts) as well as the earnings measure (e.g., does EBITDA include substantial pro forma adjustments from historical levels?) used to derive multiples.
The market-based approach is not a perfect method by any means. Industry transaction data may not provide for a direct consideration of specific company characteristics. Clearly, the more comparable the transactions are, the more meaningful the indication of value will be.
Synthesis of Valuation Approaches
A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue or earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value. A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.
Mercer Capital has long promoted the concept of managing your business as if it were going to market. In this fashion, you promote the efficiencies, goals, and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.
Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics.
We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.
For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.